Prospect Capital (PSEC) is an income-investor favorite because it offers an outsized 11.6% dividend yield, paid monthly. However, we believe Prospect is considerably less attractive than it was at this time last year. In fact, we sold our shares of Prospect last week because we believe the market cycle and unintended regulatory consequences may be turning against the company, and its valuation and dividend coverage ratio are becoming decidedly less attractive. In addition to reviewing these big risks facing Prospect, this article also highlights three big dividend investments that we believe are healthier and more attractive than Prospect Capital.
Market Cycle Risk:
In recent years, Prospect Capital has enjoyed high yields on its debt investments and high returns on its equity investments because that’s what the market cycle gave to Prospect. Specifically, as the economy continued to recover from the financial crisis, Prospect continued to benefit from investments that appeared to be “high-risk” at the time they were made, but turned out to be largely “high-reward” because the market has risen from distress to stability. For perspective, the following chart shows the “vintage years” of Prospect’s investment portfolio which constantly moves further into the future as juicy distress-year investments roll off the books and less-juicy normalized investments roll on.
For added perspective, this next chart shows Prospect’s recent quarterly investment activity in terms of what is rolling off each quarter (“Repayments/exits”) and what is rolling on (“Investments”).
And for more color, this next graphic shows Prospect’s portfolio yield, which has been declining recently, and may continue to decline in the future based on market conditions.
Worth considering, one thing Prospect likes to tout in its quarterly investment presentations is how it has delivered a higher return on equity (ROE) than its peers, as shown in the following chart.
And while ROE is perhaps a more comprehensive performance measurement than the popular net investment income (NII) because, unlike NII, ROE also captures net realized gains and losses, ROE can be misleading. Specifically, as this next chart alludes to, NII/NAV is declining, not necessarily because NII is declining (although it has in the last three quarters, more on this later) but because NAV has been increasing (relative to NII) as distressed assets purchased at distressed prices recover (and as management is perversely incentivized to grow AUM, more on this later).
And the distressed assets have recovered not just because of PSEC’s great underwriting standards, but also because of where we are in the market cycle (i.e. the market/economy has recovered, and while this is out of PSEC’s control, PSEC has certainly benefitted).
For added perspective, this next chart shows Prospect’s declining ROE in recent years as we move further away from the financial crisis vintage year originations/investments.
Worth considering, PSEC trades somewhat similarly to publically-traded high-yield debt as represented by ticker JNK and shown in the following correlation table.
Specifically, PSEC has a higher correlation to high yield debt over the last five years than it has to the S&P 500 (SPY) or to small cap stocks (IWM), which makes sense considering the types of loans PSEC is actually making (i.e. the loans, and equity investments, are being made to relatively higher-risk middle market companies). And for further perspective, high-yield bonds just had a great 2016 (and a great 8-year run, following the financial crisis) which suggest, from a contrarian standpoint, high-yield may not perform as well going forward and neither will Prospect.
For more perspective, this next chart shows the spread (versus Treasuries) for high-yield bonds has come down a lot since the financial crisis (and since early 2016 for that matter- which is important because PSEC was a lot cheaper at the start of 2016), and this suggests Prospect will likely not be able to make the same juicy-yielding investments it made during the financial crisis which it has also benefitted from in recent years because those loans lasted more than just a year or two as inferred from our earlier vintage year chart.
Unintended Regulatory Risks:
The newly-elected president of the United States is strongly in favor of less regulation, however this may have significant unintended negative consequences on BDCs, such as Prospect. As you may have noticed, financial stocks (as measured by the financial sector ETF (XLF)), shot up following November election as investors anticipated less regulation. Specifically, big banks have spent the last seven years shedding risky loans and investments from their balance sheets because of heightened regulations under the Obama administration, and this created somewhat of a boon for BDCs like Prospect (i.e. BDCs, like Prospect, picked up a lot of the business the banks were dumping or unwilling to take due to regulations). However, if regulations are dramatically reduced now, then Prospect could be facing a lot of daunting competition from the big, powerful, deep-pocketed, banks.
Perhaps compounding the risks, Prospect may have gotten “lumped in” with other financials and small caps (Prospect’s market cap is $3.1 billion) following the November election, two categories that soared as shown in the following chart.
However, given the unique risks that Prospect faces (e.g. it may actually get hurt by other financial companies like the big banks, and its high correlation with other small cap stocks, as measured by Small Cap ETF (IWM), as we saw in the earlier correlation table, may be unwarranted), its recent gains may be setting it up for a fall.
From a valuation standpoint, Prospect is significantly less attractive than it was just one-year ago. For example, the following chart shows Prospect’s current and historical price-to-NAV (Net Asset Value) and price-to-NII (Net Investment Income).
The first thing worth considering is that Prospect’s relative price is significantly higher than it was just one-year ago. And while these valuation metrics may make Prospect look cheap relative to 2010-2014, let’s not forget the market cycle. During 2010-2014 the markets, and subsequently Prospect’s investments, were distressed and thereby offering higher yields and ROEs. That is not the case today, and therefore Prospect should be trading at lower valuation multiples. And at the very least, Prospect is a lot more expensive than it was a year ago, and its prospects do not seem to have dramatically improved, especially considering it may soon be facing heightened competition.
This next chart shows Prospect’s Net Investment Income on absolute basis (in millions of dollars) and on a per share basis.
One thing worth considering in the chart is that absolute NII increased dramatically from 2010 to 2012 as the market wide recovery dictated (it created attractive opportunities) and as Prospect benefitted from big banks de-risking. Next, total NII